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1. GeKay Inc. has $20m (face value) in zero coupon debt that is due in one year. This debt has a required return of 7% and the firm's WACC is 10%. At that time (in one year) GeKay intends to sell its assets (liquidate) to pay off its creditors and then pass on the remaining proceeds to its shareholders. GeKay has 100,000 shares outstanding. If GeKay were all equity-financed, its assets in one year would be worth (market value) $30m if the economy is good (which has probability 0.6 of occurring) or $18m if the economy is poor (which will happen with probability 0.4). With the $20m in debt, however, in the latter poor economy state, the assets will be worth only $15m (not $18m) because of the distress costs associated with being unable to pay off the lenders in full.
a. What is the market value of the debt?
b. What is the market value of the firm?
c. What is the stock price?
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